Distillate Capital on Wednesday became the newest exchange-traded fund provider on the scene with the launch of its first ETF, and while the company’s name conjures images of a fund devoted to petroleum distillates, the product’s raison d'être relates to its customized approach to value investing.
The Distillate U.S. Fundamental Stability & Value ETF (DSTL) follows a rules-based index created by the Chicago-based asset manager that screens the 500 largest U.S. companies by market cap to eliminate those with less than five years of cash-flow-per-share data.
As described in the prospectus, the remaining companies are evaluated on three proprietary fundamental measures: financial indebtedness (a debt-to-income calculation is used to exclude from the index those companies with significant leverage); fundamental stability (based on a volatility measure of a company's historical and projected cash flows, with the bottom 50 percent excluded from the index); and valuation (based on free cash flow yield that’s measured by comparing a company’s normalized free cash flow to its enterprise value).
The end result is a portfolio of roughly 100 companies based on the factors of value, quality and risk.
According to a press release announcing the new ETF, Distillate believes its proprietary cash-based measure, called distilled cash yield, offers a consistent gauge of valuation by enabling the comparability between older, more physical-asset based companies and newer, more research and development-oriented ones.
Regarding the quality factor, the company says it emphasizes long-term fundamental stability over short-term price-based metrics. In addition, its gauge of financial indebtedness adjusts for off-balance sheet leases or other calls on capital that might not get picked up by traditional measures.
“Value investing works by exploiting behavioral biases, which are well-documented and recurring,” says Tom Cole, co-founder and CEO of Distillate Capital, which serves family offices, ultra-high-net-worth investors and financial advisors. “The problem lies in how ‘value’ is defined. What we’ve observed as fundamental analysts going back to the 1980s is that many traditional valuation metrics have become increasingly ineffective as tools for comparison as the economy has evolved from physical assets to intellectual ones.”
Matt Swanson, co-founder of Distillate Capital, says the proprietary metrics his company employs circumvent the inconsistent balance sheet treatment of intangible and physical investments while incorporating a company's total value.
So, what kind of fund does this produce? The new Distillate U.S. Fundamental Stability & Value ETF is heavy on information technology (31.6 percent), along with significant chunks of health care (20 percent), industrials (16.5 percent) and consumer discretionary (10.1 percent).